Stress Testing: How to Maximise Your Profits

Paul Oberschneider is the Founder and CEO of Hilltop Credit Partners. In this article, he discusses the four factors to consider when stress testing deals before applying for funding.

Development finance lenders will go through any potential property deal with a fine toothcomb when deciding whether to proceed and what rates they’re comfortable to offer. But it goes without saying that developers should stress test the deal themselves as a preliminary before applying for funding.

The 4 key metrics to stress test that will underpin maximising development returns are as follows:

Market depth and absorption

When putting together property finance, you need to know the market depth and market absorption. In layman’s terms, how many units can you sell, and how big is the market in your chosen area? These will be different for a city centre development than they will for a block of 20 flats near a market town high street or a small rural scheme.

Local knowledge is vital to stress test these metrics. Analysing the property portals and enquiring to local agents will give you a good idea of what’s selling and in which quantities allowing you to assess local supply and demand. There’s also a wealth of information at hand on market comparables using tools like Realyse and the Government’s Housing Delivery Test.

Exit route

Assumptions can be a very dangerous thing. Never just assume you’ll be able to sell all the units needed to effortlessly hit your targets. You need to be confident you’re building the right stock in the right location for the right target audience. Stress test what happens to your exit route based on different levels of unit sales over different time periods.

Also, consider your ability to refinance if needed. What would pricing be like? How much leverage can you get? Speak to brokers and banks and look at how this affects the business case for your deal.

Build costs and profitability

You need to analyse how achievable your budget is and how reasonable your profit projections are. What’s the cost per sq. ft? What’s the GDV per sq. ft? Compare these metrics with data from BCIS.

Then, run a few scenarios where your GDV and/or costs go up or down between 5 and 15% and see how the deal stacks up. If you make enough to repay your investors and development lenders under adverse conditions, you’re likely onto a winner.

This doesn’t mean you need to fixate on achieving certain levels of profitability (like getting a leveraged return on costs of at least 20%, which is something you see bandied about a lot). It’s about looking at the entire project and commercials holistically - making sure your deal will deliver. Your returns should be considered in percentages, multiples, and what you’ll make in cold, hard cash.

Project duration

The fourth key metric to stress test is how long your project will take. How will duration and – worst-case – any delays affect the deal? Will you be able to pay back loans? How will interest accrue? What happens if a loan expires before you’re finished? What happens if you have to miss payment deadlines because of delays? How will your lenders react?

Make sure you build in enough of a buffer so you can go on-site every day without worrying about the implications of missed deadlines. The best development finance lenders will scrutinise your timelines anyway, so it’s to your advantage to be realistic, not to mention honest.

Work with your finance providers, not against them. You’ll secure a better deal. Stress testing the fundamentals is the best place to start.